Recent dislocations in fixed income derivatives markets
6 December 2015
(Extract from pages 8-9 of BIS Quarterly Review, December 2015)
Recent quarters have witnessed unusual price relationships in fixed income markets. US dollar swap spreads (ie the difference between the rate on the fixed leg of a swap and the corresponding Treasury yield) have turned negative, moving in the opposite direction from euro swap spreads (Graph A, left-hand panel). Given that counterparties in derivatives markets, typically banks, are less creditworthy than the government, swap rates are normally higher than Treasury yields because of the additional risk premium. Hence, the negative spreads point to a possible dislocation. One set of factors relates to supply and demand conditions in interest rate swap and Treasury bond markets. In the swap markets, forces that can compress swap rates include credit enhancements in swaps, hedging demand from corporate bond issuers, and investors seeking to lock in longer durations (eg insurers and pension funds) by securing fixed rates via swaps. In cash markets, in turn, upward pressures on yields stemmed from the recent sales of US Treasury securities by EME reserve managers. The market impact of these Treasury bond sales may have been amplified by a second set of factors that curb arbitrage and impede smooth market functioning. First, the capacity of dealers' balance sheets to absorb rising inventory may have been overwhelmed by the amount of US Treasury bonds reaching the secondary market in the third quarter (Graph A, centre panel), causing dealers to bid market yields above the corresponding swap rates. Second, balance sheet constraints may have made it more costly for intermediaries to engage in the speculative arbitrage needed to restore a positive swap spread. Such arbitrage is sensitive to balance sheet costs because it requires leverage, with a long Treasury position funded in the repo market.
In the euro area, market tensions have been of a different nature. Ten-year swap spreads started to widen in early 2015, around the time when the Swiss National Bank abandoned its currency peg, then increased further over subsequent months (Graph A, left-hand panel). While past episodes of widening swap spreads can be attributed to credit risk in the banking sector, the most recent developments may have more to do with hedging by institutional investors. While swap rates also fell (Graph A, right-hand panel), the swap spread widened, indicating that cash market yields fell by even more. One possible explanation is that, as yields fall amid expectations of ECB asset purchases, institutional investors with long-duration liabilities, such as insurers and pension funds, would have been under pressure to extend their asset portfolio duration by purchasing additional longer-dated bonds, possibly compressing market yields below the swap rates.
In addition to extending portfolio duration by purchasing longer-dated bonds or entering a long-term interest rate swap as a fixed rate receiver, investors may also hedge the risk of steeply falling yields by purchasing options to enter a swap contract at a future date (swaptions). Hence, swaptions tend to become more expensive in times of stress and when investors rush to hedge duration risk.
As 10-year swap rates were compressed in early 2015, the cost of such options written on euro swap rates rose by a factor of three by 20 April 2015 (Graph B, left-hand panel). Steeply rising euro rate hedging costs preceded the actual correction in yields, which started rebounding around the weekend of 18 April culminating in the so-called bund tantrum. This suggests that this year's turbulence in fixed income markets may have had its origins in derivatives and hedging activity, with reduced market depth in cash markets exacerbating the spillovers.
Such volatile movements in euro area interest rate derivatives markets raise questions about smooth pricing responses in the face of possibly transient order imbalances. Of question is liquidity in hedging markets and the capacity of traditional options writers, such as banks, to provide adequate counterparty services to institutional hedgers. Looking back at the events of late April, the rise in demand to receive fixed rate payments via swaps by institutional hedgers may have run into a lack of counterparties willing to receive floating (pay fixed) rates amid sharply falling market yields. The emergence of one-sided hedging demand pressures can be gleaned from the skew in swaption pricing (Graph B, centre and right-hand panels). The skew observed for euro rates approaching the bund tantrum resembled the developments in US dollar rates in December 2008, when US pension funds rushed to hedge interest rate risk via swaptions as market yields tumbled.
There are some elements in common with the widening of cross-currency basis swap spreads (see Graph 6 and the discussion in the text), whereby supply and demand imbalances for US dollar funding interact with factors preventing arbitrage between onshore money market rates and the swap-implied US dollar rates. See D Domanski, H S Shin and V Sushko, "Hunt for duration: not waving but drowning?", BIS Working Papers, no 519, 2015. See R Perli and B Sack, "Does mortgage hedging amplify movements in long-term interest rates?", Journal of Fixed Income, vol 13, no 3, 2003, pp 7-17. See the box by A Schrimpf and R Riordan on "Volatility and evaporating liquidity during the bund tantrum", BIS Quarterly Review, September 2015, pp 10-1.